Unloved, but unbroken — the US bond market is working as it should: McGeever

ORLANDO, Florida - With US debt crossing USD 40 trillion, the budget deficit hitting 6% of GDP — a record for a non-crisis period — and the 10-year Treasury yield approaching 5%, the US bond market narrative is overwhelmingly negative. It shouldn't be.

While these numbers are undeniably large and headline-grabbing, Treasuries are performing exactly as they should.

The economy is growing at a nominal, non-inflation-adjusted annual rate of roughly 6%, with an unemployment rate of only 4.1%. That reflects a labor market that, as Federal Reserve Chair Kevin Warsh said in his Jackson Hole speech, is "consistent with full employment."

Inflation has been above the Fed's 2% target for almost six years, and the ongoing AI investment boom is the biggest in human history.

Throw in the yawning budget deficit, which most observers agree will widen even further in the coming years, and is it any wonder that investors are demanding a higher rate of compensation for lending to Uncle Sam?

So, bonds are unloved, but for good reason. The 10-year rolling return on Treasuries with a 15-year or greater maturity is -2%, the worst in more than 100 years, according to Bank of America.

Yet the market is functioning smoothly. Implied bond market volatility as measured by the MOVE index is below the averages of the last 20, 10 and, especially, five years.

Realized volatility is also low. While some foreign central banks may be reconsidering how much of their trillions to park in Treasuries, there has been no fire sale. Any reallocation away from US bonds has been gradual and orderly.

"We see nothing unusual about the current term structure of interest rates in the context of fundamental drivers," JPMorgan economists wrote on Friday.

They estimate that the 10-year yield is actually "somewhat low in our fair value framework," based on data over the last five years. "Taking a longer-term perspective, we see nothing unusual about the current level of yields either."

It might be difficult for investors under the age of 35 to grasp, but a 10-year Treasury yield of 5% is not anomalous. What is unusual is the decade between the global financial crisis and the pandemic when the 10-year yield was in a 1.5-2.5% range, even falling as low as 0.5%, due to deleveraging and unprecedented government bond-buying.

Rising bond yields may still cause problems, of course. They could become onerous for the government and the private sector, especially borrowers fueling the powerful wave of AI-related debt issuance. But everything we’re seeing — so far, at least — is broadly in line with fundamentals.

IT'S NOT UNUSUAL

The real question is whether markets will have to get used to these “higher” yields. The answer is likely a qualified “yes.”

Inflation has been above the Fed's 2% target for almost six years, meaning inflation expectations risk becoming unmoored. Consumers and businesses could be forgiven for thinking that the Fed implicitly sees 3% inflation as the new 2%. There is some evidence that it already does — the 5-year inflation outlook in the University of Michigan consumer expectations survey hasn't been below 3% for more than two years.

But market-based inflation expectations, while elevated, are more benign. The 10-year inflation breakeven rate – the difference between the yield on a nominal bond and the yield on an inflation-linked bond of the same maturity – is around 2.35%. That is hardly a panic-inducing level.

Even some of the big debt numbers that have sparked consternation in the market aren't quite what they seem. While total US debt has increased by an eye-popping USD 9 trillion, or nearly 30%, since the end of 2022, debt-to-GDP over the same period has risen by only around six percentage points, to 123% from around 117%. That’s because nominal GDP has also grown at a rapid clip during this time, expanding by more than 20%.

Finally, there is reason to believe that the recent surge in yields might not prove durable.

While there are lots of factors driving the move – fiscal fears, sticky inflation, Fed credibility, the AI borrowing binge – the bond market's turning point this year appears to be February 28 – the day of the joint US-Israeli attacks on Iran.

On the prior day, the 2-year Treasury yield closed at 3.38%, the lowest since 2022. Since then, it has risen more than 100 basis points. What's more, Fed interest rate expectations have flipped completely from three cuts to roughly three rate hikes by the middle of next year.

If the war and energy shock that followed are a key cause of the rise in bond yields and rate hike expectations, it is reasonable to assume that the end of the conflict – whenever that may be – will reverse much of that trend.

But concern over the debt, deficit, and inflation — demand or supply-driven — is warranted, and bond yields will likely remain “elevated” as a result. This isn’t an ominous sign, though. It’s a market working as it should.

(The opinions expressed here are those of the author, a columnist for Reuters)

(By Jamie McGeever, Editing by Marguerita Choy)